The SEC’s Division directors reported to Congress this week on the progress of the reforms at the Commission. SEC Enforcement brought an investment fund fraud action this week centered on luring investors with the prospect of acquiring pre-IPO shares of high profile companies like Facebook. The Commission also filed a settled action centered on the misuse of a repo transaction to dress-up the year end financial results of an investment adviser and also resolved its long running clawback action with the former CEO of CSK Auto.

The Second Circuit handed down a decision rejecting claims based on the collapse of the ASR market despite support for the plaintiffs by the SEC. At the same time, a clear split in the circuits has evolved over the application of the fraud-on-the market doctrine at the class certification stage of a securities class action as reflected in a recent Ninth Circuit decision.

Finally, the FSA sanctioned an investment firm for failing to properly comply with its rules regarding the segregation of client fund from those of the firm. This of course is a key issue in the evolving saga of MF Global.

The Commission

Progress reports: The Directors of the Division of Enforcement, Corporation Finance, Trading and Markets, Investment Management, Risk, Strategy and Financial Innovation and the Office of Compliance Inspections and Examinations testified on November 16, 2011 before the Senate Committee on Banking, Housing and Urban Affairs Subcommittee on Securities, Insurance and Investment. The testimony is titled “Management and Structural Reforms at the SEC: A Progress Report.” The testimony begins with an overview entitled “current challenges” which is followed by remarks from each Director on the recent work of their respective division (here).

SEC Enforcement: Filings and settlements

Investment fund fraud: SEC v. Mattera, Civil Action No. 11-CV-8323 (S.D.N.Y. Filed Nov. 18, 2011) is an action centered on a fraudulent scheme which claimed to offer investors an opportunity to purchase shares of pre-IPO companies such as Facebook. The defendants are John Mattera, Bradford Van Sicien, The Praetorian Global Fund and several other entities involved in the scam as well as four other individuals. Over the last fifteen months the defendants are alleged to have raised about $12.6 million from investors across the country. Acting through a number of registered and unregistered broker-dealers, and using social networking platforms such as Linkedin, the defendants solicited investments in SPVs known as the Praetorian G Entities which purported to hold shares of the pre-IPO companies. Investor funds, which were suppose to be held in escrow, were wired to a bank in the name of defendant FAST which was represented to be an escrow agent but was actually controlled by a defendant for the benefit of the defendants. The investor funds were divided by Mr. Mattera, who has previously pleaded guilty to criminal charges, and others in the scheme. The complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Sections 10(b) and 15(a). The Commission obtained a TRO and an asset freeze against several defendants. The case is in litigation. The U.S. Attorney in Manhattan brought parallel criminal charges and secured the arrest of John Mattera on charges of securities fraud, wire fraud and money laundering.

Causing a record keeping violation: In the Matter of FTN Financial Securities Corp., Adm. Proc. File No. 3-14632 (Nov. 17, 2011) is an action against FTN, a registered broker-dealer owned by First Tennessee Bank National Association. It centers on a transaction with Sentinel Management Group, Inc., an investment adviser which had under management about $1.4 billion in assets for about 100 clients but is now in bankruptcy. The Order alleges that FTN knew or should have known that by entering into a repo Transaction with Sentinel that it would be a cause of Sentinel’s violations of Section 204(a) of the Advisers Act. That section requires that every registered investment adviser keep true, accurate and current books and records relating to its investment advisory business.

The Order centers on a year end 2007 five day repo transaction between FTN and Sentinel which the latter used to temporarily pay down a portion of a bank loan the advisor used to finance trading. Sentinel represented to clients that it invested their funds in highly liquid cash management products. In fact it employed leverage to invest in a substantial amount of illiquid securities using client assets to collateralize a bank loan that financed the trading. During the consideration of the repo-transaction, FTN’s management became concerned that some of the securities it believed Sentinel had purchased from FTN on behalf of certain clients, and that the advisor wished to include in the repo, did not meet client year-end liquidity needs. Although FTN imposed restrictions on Sentinel’s future purchases, it approved the transaction. This was not the first time FTN had concerns regarding a transaction with Sentinel. Based on its collective dealings with the investment adviser, the Order alleges that FTN knew, or should have known, that the transaction would be used for an improper purpose. The action was resolved with FTN consenting to the entry of a cease and desist order based on Advisers Act Section 204(a). FTN also agreed to pay disgorgement of $1,495,878 along with prejudgment interest which will be paid into the Sentinel bankruptcy. The broker also undertook to cooperate fully with the Commission investigations and proceedings related to this matter.

Investment fund fraud: SEC v. New Futures Trading International Corporation, Civil Action No. 11-CV-532 (D. N.H. Filed Nov. 16, 2011) is an action against the company and Canadian resident Henry Roche who controlled it. The defendants are alleged to have raised over $1.3 million from investors since December 2010. Investors were solicited in the U.S. and Canada with claims that they would be paid either 5% or 10% per month within fourteen months. The money was to be invested in one of two trading schemes. In fact much of it was paid out in Ponzi type interest payments while other portions were diverted to the personal use of the defendants. The complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b). The Commission obtained a TRO and asset freeze. The case is in litigation.

Clawback: SEC v. Jenkins, CV-09-01510 (D. Ariz. Filed July 22, 2009). This is the first strict liability suit brought by the SEC under the SOX 304 clawback section. It sought about $4.1 million in discretionary bonuses and stock trading profits from defendant Maynard L. Jenkins, the former CEO and Chairman of CSK Auto Corporation. While the complaint noted that Mr. Jenkins did not participate in any wrongdoing, he was CEO of the company during a period when other executives engaged in a massive accounting fraud which resulted in two restatements. Mr. Jenkins settled with the SEC by agreeing to repay $2.8 million.

Improper fees: In the Matter of Morgan Stanley Investment Management Inc., Adm. Proc. File No. 3-14628 (Filed Nov. 6, 2011) is an action against the investment adviser alleging violations of Sections 15(c) and 34(b) of the Investment Company Act and Sections 206(2) and (4) of the Advisers Act in connection with its adviser contract to The Malaysia Fund, Inc. Morgan Stanley represented to the Fund, its board and shareholders that it had entered into an agreement with sub-adviser AMMB Consultant Sendirian Berhad, an investment adviser owned by AM Bank Group which is one of the largest banking groups in Malaysia. The purpose of that agreement was to secure advise for the benefit of the Fund. From 1996 through 2007 AMMB submitted a yearly report for the board to Morgan Stanley stating that it had provided specific research, intelligence and advice for the benefit of the Fund. This report was included with the materials submitted by Morgan Stanley to the Board in connection with the renewal of the advisory contract.

In reality AMMB provided only very limited services. Section 154(c) of the Investment Company Act requires that an adviser of a registered company furnish information as may reasonably be necessary for the company’s directors to evaluate the terms of the contact, an obligation Morgan Stanley failed to meet. The firm also failed to adopt reasonable procedures to supervise AMMB regarding the services it was to render. To resolve the action Morgan Stanley consented to the entry of a cease and desist order based on the provisions cited in the Order. The firm also agreed to repay to the Fund fees of $1,845,000, to implement certain procedures and to pay a civil penalty of $1,500,000. See also In the Mater of Morgan Stanley Investment Management Inc., Adm. Proc. File No. 3-14628 (Filed Nov. 16, 2011)(granting waiver of disqualification); In the Mater of Morgan Stanley Investment Management Inc., Adm. Proc. File No. 3-14628 (Filed Nov. 16, 2011)(waiver of certain disqualifications under the Securities Act and the Exchange Act).

Insider trading: SEC v. Longoria, Civil Action No. 11-CV-0753 (S.D.N.Y.). This is one of the expert networking insider trading cases. Mr. Longoria was formerly employed as a supply chain manager at Advanced Micro Devices. From 2006 through 2009 he is alleged to have furnished inside information to Primary Global Research LLC. He resolved the action with the Commission by consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Section 10(b). He also agreed to pay disgorgement of $178,850 along with prejudgment interest. Since he is cooperating with the Commission a financial penalty was not sought. Previously, Mr. Longoria was convicted on parallel criminal charges.

Investment fund fraud: In the Matter of LeadDog Capital Markets, LLC, Adm. Proc. File No. 3-14623 (Filed Nov. 15, 2011) is a proceeding which names as Respondents the firm, its owner Chris Messalas, and Joseph Laroco, a managing member and counsel to LeadDog. From late 2007 through August 2009 Respondents raised about $2.2 million from 12 investors for investments in LeadDog Capital LP, a hedge fund. Investors were told that the fund would be invested in part in liquid assets. Investors were also told about the securities expertise of the Respondents. These representations were false. In fact the fund invested in illiquid penny stocks. Many of the companies had received going-concern qualifications from their auditors. Investors were also not told that Mr. Messalas controlled a broker dealer that had been repeatedly fined, censured and ultimately expelled by FINRA. Respondents are also alleged to have concealed significant conflicts and related party transactions from investors and the auditors. The Order alleges violations of Securities Act Section 17(a), Exchange Act section 10(b) and Advisers Act Section 206(4). The action is proceeding to hearing.

Circuit courts

Auction rate securities: Wilson v. Merrill Lynch & Co., No. 10-1528 (2nd Cir. Decided Nov. 14, 2011) is a class action against Merrill Lynch centered on allegations of market manipulation in connection with the sale of ARSs. Plaintiffs claimed that Merrill manipulated the clearing rates through its supporting bids which sent a false signal to the market about the price and liquidity of the securities. As the markets began to deteriorate in the summer of 2007 Merrill prevented auction failure with its bids. Later the firm withdrew from the market. It collapsed. The district court dismissed the case. The Circuit Court affirmed. The decision turned on the disclosures Merrill made about its participation in the market.

The Second Circuit found there was no dispute that Merrill disclosed it routinely placed orders in the market for several purposes including too prevent auction failure. Plaintiffs argued that Merrill had a policy of placing support bids in every auction to prevent failure. In contrast, its disclosures stated that it may put in support bids. Some allegations in the complaint support plaintiffs’ contention the Second Circuit concluded. Others are much more limited and qualified. These inconsistencies on a central point are critical and undercut plaintiffs’ arguments on appeal. Likewise, while plaintiffs’ also claim that Merrill knew the market was “unsustainable,” that knowledge post dates the purchase by plaintiff Wilson and thus does not save the complaint. The fact that the SEC supported plaintiffs claims did not persuade the Circuit Court to reverse the dismissal. While the Court agreed with the SEC’s statement that in some circumstances disclosure can prevent a false signal from being sent to the market and that disclosure is insufficient if the risk is greater than what is disclosed, it disagreed with the application of these principles to the facts by the agency.

SLUSA: Brown v. Calamos, No. 11-1785 (7th Cir. Decided Nov. 10, 2011) is an action in which the court affirmed the dismissal of a class action suit based on SLUSA. Plaintiffs brought a state court class action against an investment adviser and others centered on a claim that an investment adviser breached its fiduciary duty by redeeming auction market preferred stock or AMPS to placate banks and brokers important to other funds in the family. The complaint also contained a disclaimer which specified that it does not assert a fraud claim. Following removal the district court dismissed the case under SLUSA.

Three approaches have evolved to the application of SLUSA, according to the Circuit Court. Under the literalist approach of the Sixth Circuit if the complaint can be interpreted as containing a misrepresentation, and the other requirements of the Act are met, it must be dismissed. The Third Circuit, in contrast, has concluded that if a misrepresentation or material omission is not essential to the success of the plaintiff’s claim, it is not a bar to the suit. The Ninth Circuit takes an intermediate approach which permits the complaint to be dismissed but without prejudice. Plaintiffs can then file an amended complaint in state court without the misrepresentation. In this case the Seventh Circuit concluded that the suit was properly dismissed. The approach of the Ninth Circuit is contrary to the Act the Court found. The suit here, however, must be dismissed even under more lenient approach than that of the Sixth Circuit. In this case the allegation of fraud would be difficult and maybe impossible to disentangle from the charge of breach of the duty of loyalty that the defendants owed their investors. Under these circumstances, and despite the disclaimer in the complaint, the suit is barred by SLUSA.

Class certification: Connecticut Retirement Plans and Trust Funds v. Amegen Inc., No. 09-56965 (9th Cir. Filed Nov. 8, 2011). Plaintiff brought an action against biotechnology company Amgen Inc. and several of its officers alleging the failure to disclose certain safety information regarding company drugs. The complaint alleged violations of Exchange Act Section 10(b). The district court granted a motion for class certification based on Federal Rule of Civil Procedure 23(b)(3), concluding that common questions predominated and rejecting a claim that the plaintiffs must prove materiality. Reliance was based on the fraud-on-the market theory adopted in Basic Inc., v. Levinson, 485 U.S. 224 (1988). The court refused to permit the defendants to offer a truth-on-the market defense.

The Ninth Circuit affirmed. Under Basic a plaintiff seeking to rely on the fraud-on-the-market theory to establish reliance must first demonstrate that the securities were traded in an efficient market and that the claimed misrepresentations were public. Both of these points have been admitted here. The key remaining question centers on the issue of materiality. Amgen’s claim that plaintiffs must establish materiality is incorrect since that is a merits question, not one for consideration at the certification stage of the case. This is in accord with decisions of the Third and Seventh Circuits but contrary to rulings in the First, Second and Fifth Circuits. Finally, the district court also correctly rejected Amgen’s efforts to rebut the fraud-on-the-market presumption at the class certification stage since that question also goes to the merits.

Criminal cases

U.S. v. Gallagher (E.D.N.Y. Nov. 16, 2011) is an action against Daniel Gallagher, a former stockbroker at Vision Securities Inc. of which he was part owner. Between 2009 and 20011 Mr. Gallagher is alleged to have raised about $485,000 from 13 investors based on claims that Nano Acquisition Group, LLC, formed in September 2009, would acquire the assets of Nanodynamics, Inc., a fuel cell technology company in Chapter 7. Under the terms of the offering materials no fees or salaries were to be paid until $1 million was raised. If that sum was not raised the funds were to be returned. According to the criminal complaint, all of these statements were false and the money was diverted to the personal use of the defendant. The complaint alleges wire fraud charges. Mr. Gallagher had previously been enjoined in an unrelated SEC action and FINRA had ordered Vision Securities to cease all securities business because its net capital was deficient.

Investment fund fraud: U.S. v. Gilliams (S.D.N.Y.) is an action against Tyrone Gilliams, the owner of TL Gilliams, LLC. Mr. Gilliams was indicted on charges of securities fraud and wire fraud. According to the indictment, the defendant solicited $4 million from an investor in the summer of 2010 to trade Treasury Strips, securities derived from U.S. Treasury Bonds. He diverted much of the investor money to hold a $1 million gala called “Joy to the World” at the Ritz-Carlton in Philadelphia in December 2010. Portions of the funds were also used to promote the “Gatta Be Jokin Comedy Jam” in the Bahamas and for a claimed gold investment in Ghana.


Suitability: The SRO directed Chase Investment Services Corporation to reimburse customers more than $1.9 million for losses incurred from the recommendation of unsuitable securities. The recommendations involved UITs and floating rate loan funds. The former is a product which is composed of a diversified basket of securities which can include risky, speculative investments such as junk bonds. The latter are mutual funds that typically invest in a portfolio of secured senior loans made to entities whose credit quality is rated as junk. These products were marketed by individuals who did not have adequate training to unsophisticated investors with little tolerance for risk. Chase was also fined $1.7 million.


Segregation of client funds: The regulator imposed a fine on McInroy & Wood Ltd, a discretionary investment management firm, of ?15,050 for breaching the client money rules. Those rules require that firms keep client funds separate from that of the firm in segregated accounts with trust status. The firm is required to have a trust letter from the bank holding the client funds to ensure that in the event of insolvency the client funds are clearly identified and can be properly returned. Here the firm failed to obtain a trust letter for 22 segregated off-shore client bank accounts that contained an average balance of ?666,000. The FSA has repeatedly warned market professionals that compliance with these rules is a priority.

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